** PERCENTAGES MAY NOT ADD UP TO 100% BECAUSE OF THE PROBABILITY OF LARGER OR SMALLER MOVES BEYOND THOSE SHOWN ON THIS TABLE

US DOLLAR: WHY NON FARM PAYROLLS COULD FALL BY 300K

The
sweeping victory of Barack Obama in the US Presidential Race has been
the biggest story of the day. Obama supporters are ecstatic, but the
financial markets are not. The Dow Jones Industrial Average dropped
close to 500 today while the reaction in the US dollar has been mixed.
Considering the big drop in US equities, carry trades have held up
well. With one major uncertainty out of the picture, the markets have
quickly turned their attention back to the economy. Although Obama has
been synonymous with the hope for change, many people are beginning to
realize that turning around the US economy will be a seismic challenge
for the new President.

Implications of ObamaNation on the FX Markets

Based
upon a previous study that we have conducted, over the past 30 years
regardless of what party wins the elections, the US dollar tends to
appreciate in the 6 months following the election. However the US
economy is in the worst shape since the Great Depression, which was
nearly 80 years ago. Like many of his predecessors, we expect Obama to
do no more than pay lip service to the strong dollar policy. The dollar
has already strengthened significantly and it would be
counterproductive to engineer further strength in the greenback. In
order to turn the US economy around, a weaker and not stronger currency
is needed. In this economic environment, Obama will have no choice but
to boost government spending and adopt more protectionist policies,
which could hurt the US dollar. Even though Obama has given the country
renewed hope, he wonâ€™t be able to deliver any change for the financial
markets until he becomes President on January 20th and even then, it
will take time for him to implement new policies. Therefore the
recessionary trade is still on and US interest rates are headed lower.

Non-Farm Payrolls Should be Ugly

In
the meantime, all eyes will turn to Fridayâ€™s non-farm payrolls report.
The leading indicators for NFP are in and so far, all signs point to a
very large drop in non-farm payrolls. The market is currently expecting
NFPs to fall by 200k, but traders should not rule out the growing
possibility of payrolls dropping by 300k. There is every reason to
believe that the US labor market deteriorated significantly last month.
Planned layoffs by US corporations hit a 5 year high while the
employment components of service and manufacturing ISM fell deep into
contractionary territory. Even the ADP report posted a 157k drop in
private sector payrolls. US companies have made large scale cutbacks in
anticipation of a sharp deterioration in growth and this has translated
into major layoff announcements across the nation. In the past 3
decades, there has been 3 recessions and in each of those recessions,
there was at least one month where non-farm payrolls fell by more than
300k. Given that this downturn is worst in almost 80 years, there is no
reason to believe that this time will be different and that the US
economy will be able to avoid a single month job loss of more than
300k.

Fed Changes Formula on Paying Interest

The
Fed has been struggling to put a floor under the fed funds rate but so
far, their efforts have not worked. This has forced them to change the
formula for paying interest on reserves. Prior to their announcement
today, the interest paid on reserves was 10bp below the Fed funds
target average rate and now interest is being paid at the average rate,
which basically means that they have increased the amount of interest
that they are paying on the reserves. Even though the credit markets
have been improving, the central bank and the US Treasury are still
having a tough time encouraging lending. As a result, donâ€™t expect
todayâ€™s the change from the Fed to be their last.

EUR/USD: ANOTHER 50BP RATE CUT EXPECTED FROM ECB

The
biggest event risk this week for the Euro is the European Central Bank
interest rate decision. Weak economic data and softer inflationary
pressures will force the ECB to take interest rates below 3 percent. A
rate cut will not be a surprise since ECB President Trichet warned a
few weeks ago that he plans on reducing rates at the November monetary
policy meeting. As a central banker, Trichet is notorious for preparing
the market for any imminent changes to monetary policy in the hopes
that it will reduce volatility in the financial markets when the actual
change occurs. Another 50bp point rate cut is expected and with the
strong possibility that a recession is already underway, there may be a
need for further rate cuts. We expect Trichet to retain a dovish tone
as he proceeds to close the gap between US and Eurozone interest rates
which should be Euro bearish. Downward revisions were reported in the
final October purchasing managers indexes for Germany, Italy and France
while Eurozone retail sales declined by 0.2 percent in September. As an
export dependent region, a contraction in manufacturing activity spells
big trouble for the overall economy. With interest rates expected to
fall to 2.5 percent over the next 12 months, the Euro will have a tough
time moving back above 1.35.

GBP/USD: RISK OF A 1% RATE CUT

Like
the European Central Bank, the Bank of England will also be making a
decision on interest rates tomorrow morning. However the difference
between the ECB and the BoE is that we could see a much larger interest
rate cut from the UK. To be clear, the official forecasts for both
central banks is a 50bp rate cut, but the word on the street is that
the BoE could cut by as much as 100bp. For the UK central bank, a
larger interest rate cut will depend upon how proactive the central
bank wants to be. Economic data has been very weak with the service
sector PMI index falling to a record low. Even though consumer
confidence edged higher, industrial production dropped for the 5th
consecutive month. In October, the UK government openly admitted that
the country has fallen into a recession. The European Commission
believes that of any other mature European Union economy, the UK will
suffer the sharpest contraction in growth. We expect the Bank of
England to cut by at least 75bp. A 50bp rate cut would be a big
disappointment while a 100bp rate cut is exactly what the market needs.
Either way, the outcome of the BoE rate decision should be pound
bearish. Over the next 12 months, UK interest rates could fall to below
3 percent.

DOW DROPS 486 POINTS, CARRY TRADES TO FOLLOW SUIT

Carry
trades have trailed the move in equities today. In the past, the 486
point drop in the Dow would have led to a sharper decline in the
Japanese Yen crosses. However we expect the Nikkei to follow the US
equity markets lower, which should drag carry trades down as well. The
problems in the US economy will come to forefront later this week with
the US non-farm payrolls report due for release. The data should
provide further evidence of the recessionary conditions in the US
economy. We continue to expect the Japanese Yen to outperform all of
the major currencies going forward as risk aversion remains the
predominant theme in the financial markets. The minutes from the Bank
of Japan monetary policy are due for release this evening. This will
shed more light on the reasoning behind the central bankâ€™s latest rate
cut and could provide more information on whether Japan could return to
a zero interest rate policy.

AUSTRALIAN, NEW ZEALAND AND CANADIAN DOLLARS HIT BY RISK AVERSION

The
Australian, New Zealand and Canadian dollars have been hit by a wave of
selling as equity and commodity prices turn lower. Crude prices are now
trading at $65 a barrel, which is off its recent lows but still
represents a 55 percent decline from its July peak. Australia reported
a stronger trade balance last night, but a sharp decline in the service
sector PMI report and building approvals. Employment numbers are
expected from Australia and New Zealand this evening along with the
Canadian IVEY PMI report. We expect weak labor market reports that will
confirm the need for further rate cuts in Australia and New Zealand. As
for the IVEY PMI, the drop in leading indicators points to weakness for
the key Canadian report.

GBP/USD: Currency in Play for the Next 24 Hours

GBP/USD
will be the currency in play for the next 24 hours. Traders are much
awaiting tomorrowâ€™s BoE Rate decision scheduled for 7:00am ET or 12:00
GMT.

Technically, GBP/USD price action is on the border
between the Bollinger band sell and neutral zone. It has backed off of
an earlier 250 pip rally, as it has since returned to the one-standard
deviation Bollinger band. As resistance, we will use the 10-period
simple moving average lying at about 1.600, as well as the 23.6%
retracement of the late-September highs to mid-October lows. This
creates a range between 1.600 and 1.6066. As support we will use
yesterdayâ€™s low of 1.5600, which of course will be back by lows placed
October 24th. For several days we have seen the pair unable to sustain
itself within the neutral trading zone and above the 10-day SMA. A
significant close above these levels may be followed by rallies to
October 30th highs.

About The Author

Lien
has extensive knowledge within the interbank market, particularly in
trading spot FX and options. She has written for numerous publications,
is frequently quoted on financial media outlets, and is the author of
several books, including Millionaire Traders. Read more >>

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